China’s President Xi Jinping faced two existential threats to Communist party rule when he took office 5 years ago.

He focused on the first threat, from corruption, by appointing an anti-corruption tsar, Wang Qishan, who toured the country gathering evidence for trials as part of a high-profile national campaign.

More recently, Mr Xi has adopted the same tactic on an even broader scale to tackle the second threat, pollution. Joint inspection teams from the Ministry of Environmental Protection, the party’s anti-graft watchdog and its personnel arm have already punished 18,000 polluting companies with fines of $132m, and disciplined 12,000 officials.

The ICIS maps below confirm the broad nature of the inspections. They will have covered all 31 of China’s provinces by year-end, as well as the so-called “2+26” big cities in the heavily polluted Beijing-Tianjin-Hebei area.

The inspections’ importance was also underlined during October’s five-yearly People’s Congress, which added the words “high quality, more effective, more equitable, more sustainable” to the Party’s Constitution to describe the new direction for the economy, replacing Deng’s focus from 1977 on achieving growth at any cost.

It is hard to underestimate the likely short and longer-term impact of Mr Xi’s new policy. The Ministry has warned that the inspections are only “the first gunshot in the battle for the blue sky”, and will be followed by more severe crackdowns.

In essence, Mr Xi’s anti-pollution drive represents the end for China’s role as the manufacturing capital of the world.

The road-map for this paradigm shift was set out in March 2013 in the landmark China 2030 joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition “from policies that served it so well in the past to ones that address the very different challenges of a very different future”.

The report focused on the need for “improvement of the quality of growth”, based on development of “broader welfare and sustainability goals”.

However, little was achieved on the environmental front in Xi’s first term, as Premier Li Keqiang continued the Populist “growth at any cost” policies of his predecessors. According to the International Energy Agency’s recent report, Energy and Air Pollution, “Average life expectancy in China is reduced by almost 25 months because of poor air quality”.

But as discussed here in June, Mr Xi has now taken charge of economic policy. He is well aware that as incomes have increased, so China is following the west in becoming far more focused on ‘quality of life issues’. Land and water pollution will inevitably take longer to solve. So his immediate target is air pollution, principally the dangerously high levels of particulate matter, PM2.5, caused by China’s rapid industrialisation since joining the World Trade Organization in 2001.

As the state-owned China Daily has reported, the Beijing-Tianjin-Hebei region is the main focus of the new policy. Its high concentration of industrial and vehicle emissions is made worse in the winter by limited air circulation and the burning of coal, as heating requirements ramp up. The region has been told to reduce PM2.5 levels by at least 15% between October 2017 and March 2018. According to Reuters, companies in core sectors including steel, metal smelting, cement and coke have already been told to stagger production and reduce the use of trucks.

The chemicals industry, as always, is providing early insight into the potentially big disruption ahead for historical business and trade patterns:

Benzene is a classic early indicator of changing economic trends, as we highlighted for FT Data back in 2012. The chart above confirms its importance once again, showing how the reduction in its coal-based production has already led to a doubling of China’s imports in the January to October period versus previous years, with Northeast and Southeast Asian exporters (NEA/SEA) the main beneficiaries

But there is no “one size fits all” guide to the policy’s impact, as the right-hand panel for polypropylene (PP) confirms. China is now close to achieving self-sufficiency, as its own PP production has risen by a quarter over the same period, reducing imports by 9%. The crucial difference is that PP output is largely focused on modern refining/petrochemical complexes with relatively low levels of pollution

Investors and companies must therefore be prepared for further surprises over the critical winter months as China’s economy responds to the anti-pollution drive. The spring will probably bring more uncertainty, as Mr Xi accelerates China’s transition towards his concept of a more service-led “new normal” economy based on the mobile internet, and away from its historical dependence on heavy industry.This paradigm shift has two potential implications for the global economy.

One is that China will no longer need to maintain its vast stimulus programme, which has served as the engine of global recovery since 2008. Instead, we can expect to see sustainability rising up the global agenda, as Xi ramps up China’s transition away from the “policies that served it so well in the past”.

A second is that, as the chart below shows, China’s producer price index has been a good leading indicator for western inflation since 2008. Its recovery this year under the influence of the shutdowns suggests an “inflation surprise” may also await us in 2018.

Imagine living in the capital city of a major country, and suffering the level of pollution shown in the above photo on a regular basis. We used the photo in chapter 6 of Boom, Gloom and the New Normal when we highlighted how pollution was inevitably going to move up the political agenda in China. Controversial at the time, it warned:

“Recent growth in China and India has come at a price: Poor air quality, chronic water shortages and deforestation.”

By February 2014, the pressure to act was becoming almost overwhelming as:

“The problems have worsened, to the point where almost everyone now agrees that they are creating a major political problem. The new leadership simply has to solve this, if it wants to remain in office. Beijing and the 6 northern provinces have now been shrouded in smog for 6 days, and on Wednesday the US embassy reported that the levels of PM2.5, the small particles that pose the greatest risk to human health, were “beyond index” at 512.”

Guangdong province, close to Hong Kong, had already moved to clean up. But other provinces did little or nothing, as officials worried about the likely impact on jobs. A major part of the problem was that the economy is the Premier’s responsibility, and Premier Li has been more worried about maintaining growth via stimulus programmes.

This year, however, Xi finally lost patience ahead of next month’s 5-yearly People’s Congress – at which he will be renominated for another 5-year term. Having signed China up to the Paris Agreement on climate change in December 2015, he seized control of the economic agenda, as I noted in the Financial Times:

“Xi knows that reducing pollution, rather than maintaining economic growth, has become key to continued Communist Party rule. The recent rapid elevation of Beijing’s mayor, Cai Qi, to become party chief for the city is further confirmation of the high priority now being given to tackling air pollution and stabilising house prices.

“Taken together, these policies represent a paradigm shift from those put in place 40 years ago by Deng Xiaoping after Mao’s death in 1976. This shift has critically important implications, as it means growth is no longer the main priority of China’s leadership. In turn, this means that stimulus programmes of the type unleashed in 2012, and on a more limited basis by Premier Li last year, are a thing of the past.”

Since then, the Beijing area, and surrounding provinces such as Hebei and Henan, have become a centre of the battle against pollution. One key development has been the use of thousands of drones to spot, and measure air and water pollution, and then identify and photograph the culprits. As state-controlled Xinhua reported last week:

“A total of 599 companies, mainly construction materials, furniture, chemicals, packaging and printing, were relocated out of the capital, said the Beijing municipal commission of development and reform. Beijing also closed 2,543 firms and ordered 2,315 firms to make changes. About 73% had pollution issues.”

Similarly, a senior chemical industry executive told me last week:

“I was in/near Cangzhou the other day (another city on the list) where the government have created a large National Level Economic Zone including a dedicated chemical “park” to accommodate the companies that are being cleared out of Beijing and surrounds. This was an otherwise nondescript flatland whose only previous claim to fame was a Mao era collaboration with then Czechoslovakia to make tractors.”

The war on pollution has another side to it, of course, as it marks the end of the “growth at any cost” economic model.

As a result, realism is finally returning to discussion about China’s real growth potential. As last month’s IMF Report on China noted, GDP growth had only averaged 7.3% over the 5 years to 2016 because of stimulus: without this, growth would have been just 5.3%. As a result, the IMF also highlighted an increasing risk of “a possible sharp decline in growth in the medium term”, as well as a need to boost domestic consumption by reducing savings.

This is a welcome development. Too many companies and analysts have indulged in wishful thinking, wanting to believe China had suddenly become middle-class by Western standards. In reality, as the second chart shows, the growth surge wasdue to $20tn of stimulus lending via official and shadow banking channels.

At its peak, between 2009 – 2013, this lending reached 3.2x official GDP. And GDP itself was probably also over-stated for internal political reasons, as Communist Party officials were routinely judged for promotion on their success in generating GDP growth. Now the pendulum has swung the other way, as the Caixin business magazine has reported:

“In a document jointly released by the Ministry of Environmental Protection and nine other ministry-level bodies, if a city does not achieve 60% of the emission reduction target, the city’s vice mayor will be held responsible. If the city achieves less than 30% of its target, the mayor will be held responsible; and if the PM2.5 level ends up increasing instead of falling over the winter, the party secretary of the city will be held responsible.

“Possible punishment includes party disciplinary or administrative punishments, the document says.”

Large economies are like super-tankers, they take a long time to change course. As I noted nearly 2 years ago, China is now attempting to move in a radically new direction, away from export-driven growth and infrastructure spending – and towards a New Normal economy based on the mobile internet:

“The winners are developing services-led businesses focused on China’s New Normal markets – such as those aimed at boosting living standards in the poverty-stricken rural areas, or for environmental clean-up. The losers will be those who cling to the hope that more stimulus is just around the corner, and that China’s Old Normal will somehow return.”

Those who have done well under the old regime, like the Party heads focused on job-creation and the opportunities that it created for large-scale corruption, will inevitably fight hard to preserve their way of life. Next month’s Congress will therefore be critical in assessing just how much power Xi will have to pursue his reform policies in his second term.

As I noted a year ago, this Congress will settle key questions. Will Premier Li gain a second term, and continue to be able to obstruct reform? Will anti-corruption tsar Wang maintain his position on the all-powerful Politburo Standing Committee, despite being over the nominal age limit?

The Congress is therefore likely to the most important meeting since 1997, when Jiang Zemin gained re-appointment for his second term as President and led China out of poverty via membership of the World Trade Organisation. Now, as set out in the China 2030 Report (published when Xi became President), Xi has to led China in a new direction.

□ Making China a “moderately prosperous society” by 2021 (the centenary of the Chinese Communist Party)
□ Making it a “fully developed, rich and powerful nation” by 2049 (the centenary of the People’s Republic), and returned to its historical status as the Middle Kingdom via his ‘One Belt, One Road’ project.

Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes. But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong. The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.

The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then. This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.

The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.

The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages. These are at record levels, with H1 2017 seeing 4x the number of FMs in H1 2009.

In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:

“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”

 Today, however, the pressure for short-term financial success has become intense
 The average “investor” now only holds their shares for 8 months, according to World Bank data
 This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
 And it is a very long way from the 1960s average of 100 months

As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.

ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:

“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”

The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.

THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITYThe 3rd chart suggests its end is now fast approaching. It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:

 Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
 Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
 But Wen’s tactic backfired and President Xi’s Princeling faction won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
 Li’s efforts have similarly run into the sand

As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments. But in February, Xi effectively took control of the economy from Li and put his foot on the brakes. Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:

“China’s development is standing at a new historical starting point, and … entered a new development stage”.

“Follow the money” is always a good option if one wants to survive the business cycle. We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right. But the CU% data suggests there is no hard evidence for their optimism.

There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists. With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.

Prudent investors are already planning for a difficult H2 and 2018. Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.

The clash of priorities between President Xi and Premier Li over the role of stimulus in China’s economy is close to being decided, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

The stakes are rising in China’s power battle ahead of October’s 19th Party Congress. Normally, the meeting would simply reappoint President Xi Jinping and Premier Li Keqiang for their second five-year terms. Its main business would then be to anoint their likely successors in 2022 and to replace the other five members of the powerful Politburo Standing Committee (PSC) who, by the convention known as qishang baxia, have reached the unofficial age limit of 68.

But, most unusually, signs are emerging that all may not proceed according to historical precedent. Instead, it seems that the president’s Princeling faction may have won the battle against the premier’s Populists for control of the politburo and the PSC.

Following Li’s failed “dash for growth” last year, a recent report in Xinhua, the official news agency, has suggested that Li may move to become chairman of the Standing Committee of the National People’s Congress and be replaced by vice-premier Wang Yang as premier.

This would allow Xi to consolidate his control of economic policy at Li’s expense. Top of his agenda must be the need to stem the decline in foreign exchange reserves, which have fallen by $1tn to below $3tn since their June 2014 peak. The issue is particularly urgent given President Trump’s threat to label China a currency manipulator, as the government cannot take the risk of allowing the renminbi to fall below 7 to the US dollar. As we suggested in January, interest rates have already started to rise, while capital controls have been intensified.

Commodity markets therefore seem likely to find themselves in a new round of the snakes and ladders game that began with China’s first stimulus programme in 2009. As the first chart shows, this provided a firm ladder for commodities to climb, until Xi’s first effort at reform from 2013 sent them down a snake again.

Not only did the reforms lead to a decline in total social financing (TSF) but, even more importantly, the shadow banking sector — the main source of finance for property speculation — saw its share of TSF lending collapse from 48 per cent in 2012 to 24 per cent in 2015.

Last year, however, a new ladder appeared thanks to the “dash for growth”, as the second chart shows. TSF lending increased by 14 per cent in renminbi terms, and the share lent by shadow banks rose to 28 per cent. Unsurprisingly, housing markets boomed, and Old Normal industries enjoyed a new lease of life. Oil markets also appeared to benefit as imports rose — although in reality, as Reuters has reported, “China’s additional imports of crude oil were simply processed and exported as refined products”.

Now, commodity markets may be about to find themselves at the top of a new snake. Last year’s inflationary mini-rally in commodities, sparked by Li’s policy reversal, is already running out of steam.

In oil, for example, the contango has disappeared, leading traders to start selling out of floating storage in Singapore before their profit disappears. In the west, the housing market bubbles in London and New York are also feeling the chill, as the intensification of capital controls marks the end of the Chinese-led property speculation that has powered recent gains.

The power struggle also highlights the potential importance of Xi’s recent elevation to the status of “core leader”, a title only previously held by Mao Zedong, Deng Xiaoping and Jiang Zemin. It implies that Xi’s leadership style will move away from “consensus-building” towards autocracy. In turn, this suggests that although Xi’s New Normal reforms will probably be put on hold until the Congress to avoid upsetting critical vested interests, he may well then focus on pushing through key reforms, especially the restructuring of the state-owned enterprises.

The connection was made explicit in a recent lengthy Xinhua analysis: “The new position is key for China to keep itself and the Party on the right track of development, and it marks the turning of a new chapter in the long march toward achieving the Chinese dream of national rejuvenation.”

Understandably, many investors have become entranced by the “will she, won’t she” debate now under way on whether Janet Yellen is about to raise US interest rates again. But they would be prudent to keep at least one eye on developments in China’s lending policies. Any new clampdown is likely to have a far greater and more immediate impact than any minor increases in the Fed funds rate.

One thing that “everyone knows” in China’s Tier 1 cities is that property prices can never go down. As one resident told the South China Morning Post:

“The only thing I know is that buying property will not turn out to be a loss. From several thousand yuan a square metre to more than 100,000 yuan. Did it ever fall? Nope.”

He and his wife got divorced in February, in order to buy a 4th apartment in Shanghai for 3.6m yuan (US$530k) on the basis that “ If we don’t buy this apartment, we’ll miss the chance to get rich.” And as I noted back in September, his view of the market is technically correct:

“It is also easy to forget that housing was all state-owned until 1998, and still is in most rural areas. Urban housing was built and allocated by the state – and there wasn’t even a word for “mortgage” in the Chinese language. Not only have home-buyers never lived through a major house price collapse, they have also had few other places to invest their money”.

But whilst bubbles always last longer than anyone expects, in the end they have to burst. Today, for example, unremarkable pieces of land in Shanghai are being sold at $2000/sq foot ($21500k/sq metre), nearly 3 times the average land price in Manhattan, New York.

And one sure sign that the bubble is ending, comes from the fact that “everyone” is now getting divorced in order to buy those 2 extra apartments – which will make them rich, as the Weibo picture shows.

Everyone has realised that a divorced couple can buy an extra 2 apartments with only a 30% deposit – and benefit from zero property tax. As a result, prices have risen 30% so far this year in the Tier 1 cities. Even more remarkably, prices for undeveloped land are higher than for existing apartments on neighbouring plots.

The bubble also highlights the growing split between President Xi and Premier Li over the future of stimulus policies. As China Business Review notes:

“While the State Council has always controlled economic policy, Xi has been gradually taking economic matters into his own hands since the State Council’s failures following the stock market crisis last summer. Li was noticeably absent from the Economic Situation Expert Seminar hosted by Xi in Beijing July 8, and was also sidelined at the Beidaihe Conference in August. Xi’s rejection of Li‘s stimulus approach further explains the torrent of measures issued in early October to limit housing purchases and curb overheating in the economy….

“Since August, it is increasingly common to see corruption cases featuring real estate conglomerates like Vanke and Dalian Wanda publicized…. it appears the anti-corruption campaign is being extended to deal with the housing bubble crisis.”

 It now takes $450bn of debt to create 1% of GDP growth in China (even using the “official” overstated GDP figures)
 Back at the height of the US subprime bubble, it took $350bn of debt to generate 1% of GDP growth in 2007
 China’s wealthiest man, Wang Jianlin, said recently that China’s real estate market is “the biggest bubble in history”
 He warned that prices are falling “in thousands of small cities”, even whilst they still rise in the large cities

Another worrying feature is that much of the financing for the bubble has been done in the shadow banking sector, via Wealth Management Products. As US financial magazine Barron’s warned at the weekend:

“These WMPs are starkly reminiscent of the bad mortgage-backed paper in the U.S. that metastasized in 2008 into a full-blown global credit crisis.”

So here’s the question. Would you, if you were Chinese and married, get divorced today in order to buy new apartments? Or would you have already got divorced, and be sitting back waiting for prices to rise ever higher? Or would you be shaking your head in wonder, and fearing that “this will not end well?”

Outside observers often imagine that China’s political structure is uniquely disciplined – unlike, say the US Republican Party, or the UK Labour Party, or indeed, political parties anywhere. But the fact that most arguments take place behind closed doors, and aren’t reported in the state-controlled media, doesn’t mean that the arguments don’t happen.

Yesterday’s announcement that President Xi Jinping is taking the “core leader” designation, only held previously by leaders such as Mao, Deng Xiaoping and Jiang Zemin, is thus a rare moment when the curtain is lifted and the arguments briefly enter the public domain. It highlights the intensity of the debate now underway between Xi and Premier Li over the direction of economic policy.

Li has been very active so far this year in promoting Populist policies, at the expense of Xi’s efforts to promote reform through his Princeling faction. Xi’s move therefore confirms my belief that Xi is determined to “take the pain of reform” before his expected reappointment for another 5 years at the 19th Congress in November 2017. As he emphasised in a major interview last year, before his US visit:

“Reform steps have upset the vested interests of some people, and caused changes to the career and life of some people. It is only natural that there will be difficulties. Otherwise it will not be a reform. That is why I said that we must be bold enough to crack hard nuts and ford dangerous rapids during reform and that only the daring will prevail at key stages of reform”.

This week’s developments highlight the context within which Xi is operating. His only option is to try and tighten his control of the government in response to Li’s renewed push to implement Populist policies. In turn, this confirms that fundamental economic reform depends on the President to make it happen. If Li is able to continue with his policies, and Xi loses control of the government apparatus, reform may well be abandoned.

The announcement also confirms that China’s economy is reaching a difficult stage as the country enters the critical period ahead of the 19th Congress. This is when appointments to the Politburo Standing Committee (PSC) – effectively the supreme governing body – will be finalised for the next 5 years:

 As Reuters has reported, Li is currently pushing to appoint 3 Populist allies to the PSC, which would give him a 4 – 3 majority against Xi’s Princeling faction
 In response, Xi’s strategy has been to focus on the appointments to the 25-man Politburo, which in turn appoints the PSC. This currently has a 14 – 11 Populist majority. But many will retire next year – giving Xi the opportunity to replace them with loyalists, and hence control the PSC appointments
 Another sign of the battles underway is that Xi has not yet made any moves to anoint a successor. This has led to suggestions that he may be aiming to remain in office beyond than the standard two-term ten years. But it may instead be that, as yet, he lacks the Politburo votes to impose his will

None of us know how the next 12 months will play out in China.

My personal belief, having worked with Xi’s father, is that his son has inherited his determination and courage. Therefore I suspect he will win through – but it will probably be a closely fought battle.

Prudent companies and investors would therefore be well advised to prepare for other Scenarios to develop, as it will probably be too late to react after the event.